Untangling Skill and Luck in Business, Sports, and Investing

In the book Mauboussin goes beyond the general idea that luck is important to outcomes. He explains the type of interactions where luck is important and dives into why we have a difficult time comprehending the role of luck. “The basic challenge,” he writes, “is that we love stories and have a yearning to understand the relationship between cause and effect. As a result, statistical reasoning is hard, and we start to view the past as something that was inevitable.”

Mauboussin goes on to explain how we should untangle skill and luck so we can get a feel for where they fall on the luck-skill continuum. “Where an activity falls on that continuum,” he writes “provides a great deal of insight into how to deal with it.” Skill tends to follow an arc – improving, stagnating, and then ultimately going lower.

In activities where the results are independent of one another, simple models effectively explain what we see. But when a past result affects a future result, predicting winners becomes very difficult. The most skillful don’t always win.

As a sports fan, I enjoyed the breakdown of the contribution of luck in some professional sports leagues:

And something to keep in mind, “the contribution of luck has been rising steadily over time in most sports, which means that the players are all converging on an equal level of skill.” Although, this doesn’t apply to basketball.

Automatic decision making

The problem with this sort of automatic decision-making apparatus is that it only works under very specific circumstances. Intuition works when the environment is stable and an individual has the opportunity to spend a great deal of time learning about it. . . . Trouble arises when individuals rely too heavily on their experience in making automatic decisions. When we age, we tend to avoid exerting too much cognitive effort and deliberating extensively over a decision that needs to be made. We gradually come to rely more on rule of thumb. This means that we make poorer choices in environments that are complex and unstable.

Organizations also lose skill with age.

Probably the best explanation for why companies decline is that they fall prey to organizational rigidities. Companies must balance exploiting profitable markets with exploring new markets. Exploiting known markets requires optimizing processes and executing effectively, and leads to reliable, near-term successes. Exploring unknown markets requires search and experimentation and offers none of the immediate benefits of exploitation.

Finding the best balance between exploration and exploitation depends on the rate of change in the environment. When change comes slowly, the balance can tilt toward exploitation. When it comes quickly, an organization must dedicate more resources to exploration, since profits are quickly exhausted. In general, companies tend to lean more on exploitation, which increases efficiency and profits in the short run but makes the company rigid, a state of affairs that only grows worse with age. Similar to aging individuals, companies rely on methods and rules of thumb that worked well in the past rather than embrace novelty. Companies, too, follow an arc of skill.

Mauboussin also offers some tips. Deliberate practice helps develop differentiating skill when only a little luck is involved in the outcome. That is, the larger the impact of skill on the outcome, the more effective deliberate practice becomes. On the other hand, “where luck is rampant,” he writes, “we must think of skill in terms of a process, because the results don’t provide clear feedback.”

Sometimes, of course, you want to defend against luck. If you’re a heavy favorite, you want to neutralize the other teams luck, so your aim should be to simplify the game. When you’re the underdog you want to make the game as complex as possible. Effort and strategy can compensate for skill.